Taxing Municipal Bonds

A controversial plan to tax state and local debt could rob states and localities of millions.

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

There’s an old saying that you’ll catch more flies with honey than with vinegar. As Congress considers a proposal to make municipal bonds taxable, legislators should take that adage into account.

Under a proposal by U.S. Sens. Ron Wyden, D-Ore., and Dan Coats, R-Ind., muni bond issuers would lose the tax-exempt status of their bonds, but instead receive a federal subsidy to lower their interest rate cost. The theory behind this “mandatory taxable bond” policy is that the federal government loses billions of dollars every year in income taxes evaded by super-rich investors and large insurance companies that invest in muni bonds. So it would be better to subsidize states and localities directly, as Congress did with Build America Bonds -- known fondly as BABs. Very few municipal bond issuers now sell their paper at an interest rate below the proposed subsidy level, so the economics could make sense on the surface -- if Uncle Sam could provide an irrevocable promise to pay its share, which we all know it cannot.

The bill is probably dead on arrival. States and localities will oppose the idea that Congress should tax their bonds on a mandatory basis. Even though they lost the landmark court case on immunity from federal taxation in the 1988 South Carolina v. Baker decision, they still have a solid public policy argument for preserving their historical exemption from federal taxes on public-purpose infrastructure projects. And BABs were unpopular with some members of Congress who saw them as a giveaway to underwriters.

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A number of municipal bond issuers have always been suspicious of proposals to authorize the taxable municipal bond option. They are afraid something like this new proposal could be the first step down a slippery slope that ends with Congress pulling the plug on tax benefits now enjoyed by the sovereign states. They worry that if Uncle Sam eventually runs out of money to pay for anything besides the military (“the common defense”), its own debt and our social entitlement programs, there won’t be money to pay the promised subsidies on muni bonds. Current fiscal projections by the Government Accountability Office show that scenario no later than 2030, before some of today’s bonds would mature. Of course, that doomsday scenario offers little solace that Congress would not begin taxing muni bond interest anyway.

Taxable muni bonds have a worthwhile place in the public finance system. They permit issuers to tap into markets that traditional tax-exempt bonds cannot reach, such as pension funds and foreign investors who do not pay U.S. income taxes. Those markets are too large to ignore, and they would be accessible for muni-bond issuers -- as long as the federal subsidy is reliable and calibrated properly.

But the proposal to make all municipal bonds taxable is a bad idea that smells like vinegar. Congress should instead provide honey to state and local issues of muni bonds to enable them to make rational decisions that benefit both federal and municipal taxpayers. They could simply reduce the reimbursement rate previously paid for BABs -- 35 percent -- to something that makes sense for the long run. The proposed bill suggests 25 percent. That’s too stingy. State and local leaders should channel the energy behind the Wyden-Coats bill to promote a five- or 10-year extension of the taxable bond option at a reimbursement rate equal to the weighted average marginal tax rate of muni-bond investors. In today’s income tax schedules, that should be around 30 percent, which is still wider than the spread between muni bonds and taxable paper for many issuers.

Every dollar borrowed by state and local governments under this approach will cost the federal government less, and municipalities will use the tool only when they know it works to their advantage. If Congress later raises the upper-income tax rates to Clinton-era levels, my formula would automatically raise the taxable bond subsidy rate commensurately.

Yields on traditional tax-exempt bonds will decline as some of the supply is channeled into markets that issuers cannot otherwise tap. It’s a win-win if done properly.

This column is adapted from its Web-first publishing on April 14, 2011.